Offensive Risk Management: Can Tail Risk Hedging Be Profitable?
20 Pages Posted: 24 Mar 2010 Last revised: 6 Apr 2010
Date Written: February 2010
Long-horizon investors have traditionally assumed that they do not need to purchase insurance against rare but severe events that can adversely impact their portfolios. Even where insurance is justified, it is interpreted as a “cost” that reduces the potential returns of the portfolio. In our conversations with investment officers, the biggest challenge that they face is the uphill battle convincing investment committees to commit to this cost and potential of relative underperformance to the peer group. But this “defensive” paradigm for purchase of portfolio insurance hides the fact that severe market crises create opportunities for investors who have maintained or have access to liquidity. The purpose of this paper is to illustrate that the opportunity to increase risk exposures in a tail event improves the return distribution of most investment portfolios. We have discussed the concepts behind offensive risk management earlier in Bhansali (2008). The current paper digs deeper into the theory and produces a simple model to support the concepts. More precisely, we show that the “shadow” value of a tail hedging program is positive.
Keywords: Tail Hedging, Asset Allocation
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